The Rise Of Federal Merger-Challenge Lawsuits And The Hurdles Plaintiffs Face

The pattern is familiar: A proposed merger or acquisition involving a publicly traded company is announced and almost immediately law firms issue press releases announcing "investigations" into whether the target company and its board of directors breached their fiduciary duties. The press releases encourage shareholders who would like to know more about their rights to contact the law firm. Then — sometimes as soon as within 24 hours of the announcement of a transaction — merger-challenge lawsuits begin to be filed in the state courts of the target company's state of incorporation and the state in which it is headquartered. They allege breaches of state-law fiduciary duties based on allegations that the purchase price is too low and the result of a flawed process, that the deal protection devices in the merger agreement are preventing the target from obtaining higher offers, and — after the preliminary proxy statement is filed with the Securities and Exchange Commission (SEC) — that the disclosures made to the target's shareholders are insufficient. Increasingly now, however, another set of lawsuits is being filed: federal securities-fraud lawsuits alleging disclosure violations under Section 14(a) of the Securities Exchange Act.

A recent analysis of securities class-action filings found that almost one-fourth of all securities class-action lawsuits filed in the first half of 2011 challenged the disclosures made to a company's shareholders in connection with a proposed merger or sale of the company.1 This continues a trend that began last year2 and is likely an outgrowth of the recent large increase in the number of public-company mergers that are challenged in state-court lawsuits.3 Despite this increase in Section 14(a) suits, however, it is not clear that federal merger-challenge lawsuits will, in the long term, provide a viable alternative to state-law fiduciary-duty claims.

As we explain, plaintiffs face a number of strategic and tactical problems in bringing what are essentially state-law fiduciary-duty causes of action as federal securities-law claims. The usual form that merger-challenge lawsuits take and the manner in which they typically are prosecuted in state courts simply are not compatible with federal law, especially the Private Securities Litigation Reform Act (PSLRA). Therefore, while the current increase in federal-court merger-challenge lawsuits is likely to continue for now, such cases may decline as the case law catches up with the plaintiffs' bar's ingenuity.

Increased Competition for State-Law Merger-Challenge Work Is Leading Law Firms to File Federal Actions.

Probably the most significant factor leading to the increase in federal merger-challenge lawsuits is that the market for law firms that file these lawsuits appears to be oversaturated.

A meritorious merger-challenge lawsuit can generate tens of millions of dollars in fees. But even a meritless merger-challenge lawsuit can generate tens of thousands, if not hundreds of thousands, of dollars in fees, as companies frequently settle groundless lawsuits simply to gain deal certainty and because often such lawsuits can be settled for significantly less than the cost of defending them.4

Moreover, the barriers to entry are relatively low for a plaintiff's attorney who wants to do merger-challenge work. All an attorney needs is a shareholder who is willing to serve as a plaintiff. Even if that shareholder owns just one share, that is sufficient to allow the attorney to file a lawsuit and have a chance of getting some portion of any fees generated. If that lawsuit is also the first filed, then the lawyer has a significant chance of controlling the subsequent lawsuits that normally are filed and consolidated in a particular jurisdiction.5 An attorney can attempt to find a shareholder willing to serve as a plaintiff simply by issuing a press release posted to the internet announcing an "investigation" of the proposed transaction that insinuates that it is unfair and that encourages shareholders who want to know more about their rights to call the law firm.

A good illustration of this is the proposed acquisition of El Paso Corporation by Kinder Morgan, Inc., which was announced on October 16, 2011. That same day, law firms began...

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